Meaning of Dividend, its Yield, Effects and Dividend Policy

“You should always check the dividend distribution history of a company before investing in its shares“. Someone or the other must have given you this suggestion?

Paying attention to dividend distribution is one of the most repeated suggestions given to a layperson intending to invest money in the share market. However, RiseMoneyWise wants you to make informed decisions instead of blindly following suggestions. So, here we are with a detailed article about the dividend. This write-up will help you understand what is dividend, its meaning, and its importance.

What is a Dividend?

A dividend, in simplest terms, is the company’s profit that is divided among its shareholders. What percentage of total earnings will be distributed among shareholders is decided by the board of directors of the company.

Dividends are often divided among shareholders on a quarterly basis. These can be paid out in cash or may be given in form of reinvestment in additional shares of the company. Every common shareholder of a company who holds stock before the ex-dividend date is eligible to receive the dividend.

You must know that the dividend of a company does not directly reflect a company’s earnings or its profit. The Board of Directors may decide to reinvest the earned profit into the company and not pay the dividend, even after a huge profit. On the other hand, a company with a much lower profit margin may as well decide to distribute dividends to maintain its distribution track record.

Dividend-Related Terms You Need to Know

Dividend Yield – Dividend yield is defined as the dividend per share. It is often expressed in terms of the percentage of a company’s share price. The dividend yield is calculated by dividing the annual dividend of the stock by the stock’s trading price.

For example, if the share of a company ABC is priced at $100, and if the company pays $7 in dividend this year, then its dividend yield is 7% (because $7 is 7% of $100).

Announcement Date – The announcement or declaration date is the date on which a company’s management announces the dividend. The amount announced is to be compulsorily approved by the shareholders before it is paid.

Ex-dividend Date – Ex-dividend date is the date on which a company’s dividend allocations have been specified. It is typically one day before the record date of the dividend announcement. Anyone who buys a stock on the ex-date or later is not eligible for the dividend declared on the record date.

Record Date – It is the cut-off date chosen by the company to determine which shareholders are eligible to receive the announced dividend.

Payment Date – It is the date on which the company pays out the dividend and the amount is credited to the investors’ account.

Why Do Companies Pay Dividends?

You might already know that shareholders are the part owners of a company. So, paying off dividends is like handing over the profit of the business to its owners by the management. However, the management cannot give away its entire profit to its owners; it needs to hold a certain amount to reinvest in the growth of the business. Hence, the management has to decide what percentage of profit is to be reinvested and what percentage is to be given to the shareholders.

Management of a company typically pays a dividend to the shareholders to convey that the management is working efficiently and the company is earning profits. Dividend puts a company in a positive light for the investors. It also maintains their trust in the management of the company.

Blue chip companies often pay dividends to their shareholders.

Inferences Drawn from Dividend Payment

As discussed earlier, dividend does not automatically reflect a company’s profit margin or operational efficiency. But, people tend to draw inferences based on the announced dividend by a company.

A high dividend may indicate that the company is doing great and has generated good profit. But, this may also be an indicator that the company does not have any suitable project for reinvestment of profit for future growth prospective.

A reduction in the dividend amount of a company with a track record of good dividend payments over the years may indicate trouble in the company. But, again this is not always the case. The reduction may be because the management has some high-return projects in their plan that may compound the future growth of the company.

Effect of Dividends on Stocks

Though dividends do not have any direct relation to share price they can have an indirect impact. A company that regularly pays a dividend will have a good rapport in the market. Hence the company can attract more and more investors. This can lead to an increase in share price in the market.

Dividend announcements also exhibit some instant impact on the share price. Typically share prices rise on the announcement of a dividend. This rise is approximately equal to the announced dividend. And, this rise generally reverses on the opening session of the ex-dividend date. There’s no rule but investors often observe this price adjustment in almost every dividend declaration.